My portfolio has been in transition since 2015, moving further towards a high-yield income strategy, and away from individual stocks and their single-issue risk in favor of the diversification offered by funds – mainly closed-end funds (CEFs) and ETFs. The original portfolio already included higher-yield positions such as Omega Healthcare Investors (OHI), Hercules Capital (HTGC), Main Street Capital (MAIN), Starwood Property Trust (STWD), and Gladstone Investment (GAIN), and both Hercules and Starwood have survived the transition.
But most other stocks have been replaced by CEFs or ETFs, increasing the portfolio distribution yield from around 7% to around 9%, with most positions now in the 7%-9% range. This places my holdings squarely in the "income factory" approach of Seeking Alpha contributors like Steven Bavaria, although Mr. Bavaria does appear to target higher distributions in the 10%-13% range.
The key challenge with this approach is implementing a set of risk reduction strategies. Whereas a blue chip portfolio would most likely continue to increase its dividend payout faster than inflation through good times and crises alike, a high-yield portfolio will not.
Distributions are rarely increased, and are quite often cut, so the investor needs to find ways to offset both the cuts themselves and the impact of inflation, which is not being compensated by rising dividends. This article makes five suggestions for reducing the risk of this portfolio type – but not eliminating the risk, which is obviously impossible for any equity portfolio, even one based on dividend champions.
This is standard advice for any portfolio, but some high-yield investors may fall into the trap of thinking they have achieved sufficient diversification because their various funds may each hold 50, 100 or 150 positions. That’s an excellent start, but the portfolio should also be diversified across the funds by business activity, geographic zone, and even management company – because management can change, or lose touch with markets, or simply decide to bite the bullet and cut distributions on all its funds simultaneously.
My portfolio heavily overweights the US, which remains the deepest and most dynamic market available, but it also has significant exposure to Europe, Asia/Pacific, and the emerging markets. Sector exposure includes infrastructure, healthcare, tech (focused on non-FAANG stocks), MLPs, and commercial mortgage-backed securities, although many funds simply represent a broad market strategy within a geographic region. Apart from two CEFs run by the same management company, diversification by management company is near total, although I would not hesitate to add additional funds from the same stable if warranted by quality.
High-yield portfolios are more volatile than most, so it’s important to quantify what that might mean for your specific holdings via back-testing. This is most useful for funds/companies that have been in existence since at least before the last financial crisis, since a crisis is a harsh test, but even an analysis of the last five years can be useful.
I back-test primarily for income, given the focus of the strategy, but total return is still relevant, because if a fund’s net asset value (NAV) declines too dramatically, that is often accompanied by declining net investment income and/or option income, eventually leading to a distribution cut. I focus on NAV without dividends reinvested, and on a 3+ year time frame to smooth out short-term fluctuations in underlying business sectors or geographic regions.
The income back-test of my high-yield holdings that existed by 2008 shows a 27% income drop in the crisis (2009/2010) and a 2.6% per year income decline for the 10-year period 2008-2018. Add in some inflation, and this supports the idea that high-yield investors should be reinvesting at least half their income to make the other half sustainable in terms of purchasing power. If a portfolio is generating 10% in income, then at least half, 5%, should be reinvested to cover, say, 2.6% in distribution cuts plus 2.4% in inflation, although these numbers will fluctuate and the reinvestment plan will need to adapt.
An income back-test will probably identify certain positions that fared better in a crisis than others, or positions that offer a counter-cyclical income dynamic, actually performing worse in a crisis but providing rare distribution increases at all other times. It may make sense to overweight such positions to increase the income resilience of the entire portfolio.
In my case, I overweight (full position plus 50%) the Credit Suisse Asset Management Income Fund (CIK), a US-focused corporate junk bond CEF that cut distributions only 11% during the crisis, and Ares Capital Corporation (ARCC), a business development company that cut 16%. Both positions recently increased their distributions, but while that is a good sign, it is not necessarily the start of a trend. I am also overweight the Cohen & Steers Infrastructure Fund (UTF), which cut its distribution around 50% during the crisis, but actually increased its distribution 144% in the 2004-2008 period and by 29% in the 2013-2018 period.
Reinvestment – Even In Retirement
As shown earlier in the back-testing discussion, reinvestment is critical to offset distribution cuts and inflation, thereby maintaining the purchasing power of the income stream. The reinvestment plan needs to adjust to changes in those two factors, and it also needs to continue during the retirement or distribution phase, unless the investor is prepared to liquidate shares or downsize household spending.
If I find my income stream cut by 25% or 50% during a financial crisis, then I think there is a compelling argument to stop spending the distributions and instead reinvest them 100% in shares that would no doubt also have collapsed in price. This could generate outsize capital gains when distressed assets finally recover, and multiply the effect of any post-crisis distribution increases.
Barring other sources of income, like social security and private pensions, this approach would require a cash reserve covering at least two years of expenses. There would be an opportunity cost in terms of foregone distributions or interest, but I think that would be justified to make the high-yield strategy viable even across market crashes.
This article suggests reducing high-yield income strategy risk by diversifying the portfolio across positions by business activity, geographic region and management company, back-testing the income performance of the positions, overweighting those that hold up best in crisis, reinvesting a large proportion of distributions, even in retirement, and maintaining a cash reserve to allow 100% reinvestment during market crashes.
These suggestions may help in the management of high-yield strategies, but such strategies remain risky and volatile, and investors need to be psychologically able to handle that high volatility. Otherwise, they will end up capitulating and selling in the depths of a recession, destroying both capital and income.
Disclosure: I am/we are long ARCC, CIK, UTF, HTGC, STWD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.